The Truth Behind American Capital's Share Buyback

Fool analyst Rich Smith recently discussed business development company American Capital's (Nasdaq: ACAS) decision to repurchase millions of its own shares at the end of last year -- for those of you wondering, American Capital is also the parent company of the popular mortgage real-estate investment trust American Capital Agency (NYSE: AGNC) . Rich found the decision imprudent, given that the company can't afford to pay a dividend and is still recovering from the massive $4-billion-plus losses it suffered in the financial crisis.

As often happens with our articles, a handful of readers disagreed with Rich's assessment. They argued that the decision was good for shareholders because American Capital's shares are trading for a fraction of book value, a commonly used valuation metric for business-development companies. According to one reader, "[American Capital] has been trading around 60% of book value. Buying back shares is giving way more value to shareholders per dollar than paying a dividend would. Would you rather have [a $0.60 dividend], or buy a dollar for [$0.60 with a share buyback]?"

Given my affinity for financial stocks -- not to mention a recent interest in business development companies -- I've decided to jump into the fold. And it so happens that I, like Rich, believe American Capital's decision represents an imprudent allocation of capital. Before getting to the reasons why, however, I wanted to discuss buybacks more generally for those of you who are new to the debate.

A brief background on share buybacksIt's hard to dislike the idea of a share buyback. By repurchasing their own stock, companies reduce the number of pieces that the corporate pie is divided into, leaving existing shareholders with a larger slice of everything from net assets to earnings. Similar to a typical stock purchase, however, the prudence of a specific repurchase program comes down to timing: A company wants to buy low and sell high.

Berkshire Hathaway's (NYSE: BRK-B) decision to repurchase shares at the end of last year provides a great example of the thought process behind a profitable buyback. In announcing its decision, Berkshire's board of directors stated their opinion that "the underlying businesses of Berkshire are worth considerably more than" the current price. Its shares at the time were trading at 1.02 times book value, or about 50% below their historic average. The shares have since increased in price by nearly 11%, providing the company and its existing shareholders with an annualized gain of 34%.

Unfortunately, Berkshire's experience in this regard appears to be an exception to the rule. My colleague Morgan Housel has written about this on numerous occasions. He disclosed the hundreds of millions of dollars that Circuit City, Countrywide Financial, and Citigroup (NYSE: C) sunk into ill-timed buyback programs in 2006. He discussed how banks like Bank of America (NYSE: BAC) and Goldman Sachs spent billions of dollars buying their own shares at the height of the housing bubble, only to watch as the market collapsed soon thereafter. And in an article last year, Morgan offered a revealing chart that shows the inverse relationship between share buybacks and subsequent returns.

Where does American Capital fall?At first glance, it's tempting to conclude that American Capital's recent repurchase program has more in common with Berkshire's than it does with Circuit City's or Bank of America's. In the first case, the company's share price appears closer to the market bottom as opposed to its top, as its shares have fallen by more than 80% since mid-2007. And in the second case, its shares were trading for 36% less than book value during the program -- that is, American Capital's book value per share is $11.92 whereas its average repurchase price was $7.61 per share, according to Yahoo! Finance.

However, a closer look suggests this conclusion may be premature. Remember what I said about the strategy underlying a share buyback? You want to buy low and sell high. American Capital appears to, well, have done the opposite. According to a recent quarterly filing (page 67): "In April 2010, we completed a registered direct offering of 58,300,000 shares of our common stock to a group of institutional investors at a price of $5.06 per share" (emphasis mine). In other words, the company effectively sold 58.3 million shares for $5.06 a share in April of 2010 only to repurchase 17.5 million of them a year and a half later for an average of $7.61 a share. So no matter which way you slice it, it's hard to disagree with Rich's assessment of American Capital's buyback decision.

Foolish bottom lineAt the end of the day, I have to admit that I strongly dislike share-buyback programs -- unless someone like Warren Buffett is calling the shots, that is. While their stated purpose is to increase shareholder value, I believe their true purpose is more typically to mask executive stock grants by counteracting what would otherwise be a dilutive form of compensation. If you disagree with this or my analysis of American Capital, I encourage you to say so in the comment box below.

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Comments from our Foolish Readers

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I wanted to add that when Countrywide did their stock buyback, they also simultaneously issued new debt to fund it, all while the insiders sold all their shares..basically propping up the stock price as they sold millions of shares into the market. That was all right at the end. I only noticed because I had a ton of Put options that expired worthless right before the stock tanked and I couldn't figure out how the price was staying so high while all the other sub-prime and stated loan servicers and lenders were going to zero.

The whole idea of selling shares at $5.06 to some "institutional investors" and then buying some of them back at $7.61 seems a bit curoius. As, both John and Rich said, usually you want to see the opposite and I agree. Makes me wonder who's doing the laundry and who's making out with clean socks?

I can't agree with the reasoning here at all - but to understand why you need to know what happened since april 2010. ACAS went into default on it's loan covenants during the crash of 2008. This was cause by falling asset values that were 'marked to market' and resulted in a situation in which the company's assets fell below required 2x debt levels. The "institution investor" (RE: Paulson) that purchased in 2010 did so while the debts were defaulted, and therefore there was a bona fide 'going concern' issue for the company. However, since then, the company has recovered, and, last year, reached an agreement with it's lenders that removed this concern. Furthermore, during the entire period of default and subsequently, the company has remained profitable, albeit not as profitable as before the crash. By this past fall (2011), Paulson was under pressure due to redemptions and has needed cash. This is partly what has driven the stock price well below the NAV, as well as concern over the european subsidiary ECAS. What your article in particular doesn't mention is that the stock price was as high as $10.85 just prior to Paulson selling a large portion of his stake in the company.

The bottom line is that stock repurchase is a great idea IF the stock is really worth the NAV that the company has reported, and a bad idea if the stock is not worth more than the price paid for the shares. I agree that many companies misjudge and buy their shares back when they are overvalued. I don't believe that to be the case here; time will tell.

Below my comments, I quote a paragraph from your article, in which you mentioned a stock sell in 2010. Here is my comment. Yes, that sell price in 2010 was below recent buyback price. However, you did not mention why the company had to sell shares at that time. Time changes and the company's position changes. Your conclusion about company's recent buyback is not a well-informed conclusion. You need to understand what was the position of the company in 2009 and 2010.

Here I quote your paragraph:

"However, a closer look suggests this conclusion may be premature. Remember what I said about the strategy underlying a share buyback? You want to buy low and sell high. American Capital appears to, well, have done the opposite. According to a recent quarterly filing (page 67): "In April 2010, we completed a registered direct offering of 58,300,000 shares of our common stock to a group of institutional investors at a price of $5.06 per share" (emphasis mine). In other words, the company effectively sold 58.3 million shares for $5.06 a share in April of 2010 only to repurchase 17.5 million of them a year and a half later for an average of $7.61 a share. So no matter which way you slice it, it's hard to disagree with Rich's assessment of American Capital's buyback decision."

I want to say that this is the second article from Motley Fool discussing ACAS recent buyback negatively. I found that both authors do not understand ACAS and both did not bother to discuss the process that ACAS navigated through during the past few years, since 2008.

John, and Rich, if you bother to read the filing's, listen to a conference call, or an investor presentation, you would understand why the company is buying shares back. More importantly You would know why they were forced to sell share's below book value. You have failed to educate your readers with a less than flattering rendition, to a much longer tale.

As an investor in ACAS, I am quite happy with the buybacks. When American capital trades above book, or it re-RIC's their will be fewer share's outstanding, allowing a larger dividend to be paid out.

I don't get it, BRK-B stock buyback was a good idea because it bought back shares at ABOVE book value and there was a run up of about 11% in share price subsequent to that.

But ACAS buyback was a bad idea because it bought back shares at BELOW NAV and there was a run up of about 11% in share price subsequent to that.

Again, my criticism is purely on the weak arguments given by Rich in his discussions regarding ACAS and now by John in the above article. It just seems the research was lazy and superficial. Or maybe the editors at MF are to blame for allowing these articles to come up.

I value criticism on the companies that I follow or I own. Helps me to assess and then reassess stocks, companies's management and my portfolio. But the level of research in Rich's and John's articles with regards to ACAS is so frustratingly inadequate.

How can a 2010 transaction for a financial be discussed in comparison with a late 2011, early 2012 strategy, with NO background provided? The world has changed, as well as ACAS's situation. I am disappointed to find such poorly researched articles in this space. The merits or shortcomings of ACAS's buyback requires much more research than has apparently been done.

Once again , a Motley Fool contributor using minimal information in which to form and opinion. The information Mr. Maxfield uses to buttress his opinion is based in factual information garnered from SEC filings but going back two years may not be enough.

That sale was to rectify the debt to asset ratio that at the time hindered the debt ( whole other story and topic). As it stands to day ACAS NAV ( Net asset value) is close to $12. and the stock is selling around $8.50. Screaming bargain!!!, will this be the price a quarter from now? Probably not. If the company sold those buybacks today they would make a profit, but chances are very good, when they resume the dividend payments (presumably late 2012 or early 2013) and the asset values continue to rise along with the economy the share prices will also rise closer if not greater than the NAV.

Mr Maxfield do you expect ACAS to sell these shares for less than the average buyback which is approximately 7.60 ( guesstamation)? or greater? What they had to sell shares at two years ago is irrelevant, what they sell them for two years from now will then affirm your assumptions.

... and true to form .. high on assertions and low of facts and analysis.

So, our new entrant Mr. Maxfield adds the idea of the sub-NAV sale to Poulson's group in 2010 to counter a buyback strategy now without ANY context of WHY it was in ACAS's best interest at the time to sell those shares .. WHY it needed the cash at that time and how that facilitated ACAS's recovery.

STILL no discussion regarding the losses carried forward and the c-corp convert.

STILL no discussion of in the light of those losses carried forward, dividends would be a return of capital

STILL no discussion of SOMETHING AS SIMPLE AS THE RATE OF RETURN that ACAS's buybacks represent to the shareholders and how that compares to ACAS's opportunities for return via other investments.

The introduction of the idea that ACAS solds shares at one point at one price and now is buying back at another simply doesn't take into consideration ANY opportunity-values AT EACH OF THOSE TIMES and what the transaction (selling or buying) represented AT THAT TIME.

Also, NO discussion of the relative discount to NAV at the time of the sale at ~$5 and how that compares to the discount to NAV at ~7.5.

Don't you think the relative discount value of the sale in 2010 to the buybacks in 2011/12 would be pertinent?

Apparently not.

So, by Mr. Maxwell's thesis, if you held a stock and sold it at $5 last year .... lets say because you needed to put a down payment on a car .. so you could get to work at a new job (something important for your continued success) .. but as you watch the stock you see it a great value at $8 .. you shouldn't buy it .. because you sold it in the past at $5?

Wow .. now that IS something.

Again, I assert my original thesis, that the MF'ing writers aren't really interested in fundamental understanding .. they are interested in page-views .. and Mr. Maxfield's current piece is simply that .. a purposefully fact-light and meaning-obscuring piece meant only to generate responses from those who actually know the facts (and thus page view) rather than something that means to inform.

Many of you have expressed concern that I didn't provide more background to the 2010 issue for $5.06 a share to Paulson and the 2011 buyback for an average of $7.61 a share.

And I concede, I didn't.

The reason being, we're limited in space in these articles and we have to pick and choose what to include. It's for this reason, that I included only the broadest information. In doing so, I figured that those of you who knew more could fill in the blanks. And those who knew less, would look into the matter further before making an actionable decision.

That said, I struggle to understand how anybody could interpret these events in a positive light. ACAS's management acted negligently by positioning the company in such a way as to put it into default. To extricate themselves from their own mistakes and thereby ensure the continuation of their exorbitant pay packages (unlike the dividends, of course.....), they issued new shares at a fraction of book value, thereby diluting the holdings of existing shareholders.

Now I understand that this had to be done to save the company. But the fact of the matter is, existing shareholders suffered while the executives continued to receive multi-million dollar compensation packages.

At the most basic level, I see this as a violation of the executives' duty to put shareholders' interest before their own. This is serious to me as an investor, and I wouldn't touch a company that was led by a team of executives that did so.

If you feel comfortable with it after conducting your own due diligence, then by all means, go for it. But if you're a new investor without the time and expertise to study the issue thoroughly, then steer clear.

There are thousands of stocks you can buy, why choose one with a proven history of executive negligence?

So it sounds like your article should have been posted 2 years ago - and focused on the equity sale below NAV to Paulson. Yes that was bad, but necessary - but also in the past.

Now ACAS is buying back shares at a 40% discount - this is good - no connection to the past sale.

You could argue that ACAS has a poor management team by only posting what everyone has known for several years - the forced equity sale in 2010, but this has nothing do do with the current buyback! The two are exogenous events and not correlated in any way.

I only look to future events(all future cash flows - CAPM) when analyzing equities, and these current buyback's increase all future positive cash flows per share of ACAS stock....

First, the sale to Paulson is admittedly old news. But the recent buyback isn't. And the Paulson sale is necessary context for the recent buy -- for a variety of reasons, only one of which is that it provides a benchmark against which we can judge the buyback.

Second, evidence of past mistakes is relevant looking forward -- generally not in the court of law, of course, but we're not in the court of law. For example, you wouldn't hire Andrew Fastow as your CFO even though his malfeasance occurred ten years ago.

Third, a bird in the hand is better than two in the bush. We could argue all day about ASAC's NAV, but the reality is, that number is controlled by ASAC's management and board, regardless of how much we'd all like to believe otherwise. So comparing a buyback to a dividend using that number isn't apples to apples. And that's why if I were an ASAC shareholder, I'd just as soon have my dividend payment in the bank.

Finally, I agree that looking to the future is better than living in the past. That said, the future doesn't exist in a vacuum, it is a continuation of past events. A wise man once said... "Fool me once, shame on you.... Fool me twice ....." You get the point.

To those of you unfortunate few who have read all the way to this point, here is the "truth behind these sells and buy" as I see it.

The truth behind the 2010 sale is this: ACAS was backed into a corner because it was desperate for capital. Smelling blood in the water, a shrewd hedge fund manager by the name of John Paulson exploited the opportunity and negotiated a deal, buying shares for a fraction of book value -- thereby diluting existing shareholders.

The truth behind the 2011 buyback is this: Paulson purportedly needed cash to satisfy redemptions. To get said cash, he decided to sell a portion of his interest in ACAS. Because it would be such a large block, ACAS decided to buy some of it back to stem the decline in its stock price.

These, of course, are my opinions extrapolated from the facts as I see them. That said, if I were an investor, I'd nevertheless hesitate to give ACAS's management the benefit of the doubt given its past performance.

>> I struggle to understand how anybody could interpret these events in a positive light. ACAS's management acted negligently by positioning the company in such a way as to put it into default.

Mr. Maxfield,

It seems strange for me to have to inform you about this .. BUT THAT'S NOT WHAT YOUR ARTICLE WAS ABOUT.

Your piece, and the pieces you came to the defense of, were discussion of WHETHER OR NOT THE BUYBACKS ARE GOOD FOR CURRENT SHAREHOLDERS ... TODAY.

They WERE NOT whether or not ACAS was prepared for a financial meltdown.

Having a discussion with you is like arguing with one of those Tea-Party nuts .. as soon as you try to pin them down on any economic specifics, they turn the discussion to the President's birth certificate.

We all deserve better .. better research, better rationale, and better pieces out of published investment writers.When ACAS makes the decision to buyback shares, they aren't making that decision 2 years ago or 4 years ago ..

... they are making that decision TODAY

Looking at ACAS .. TODAY

with its investment prospects .. TODAY

with its losses carried forward .. TODAY

with its discount to NAV ... TODAY

with its D/E .. TODAY

with its cash on hand ... TODAY

where it is on its loan paybacks .. TODAY

Is buying back the shares good for current shareholders?

If you bother to really look at the data, listen to the conference calls and understand what is going on at ACAS, you would finally be in a position to write an article worth publishing.

I guess if ACAS had x amount in earnings that would go to 1) buybacks; 2) dividends; or 3) some form of investment or debt buyback - I guess the policy they stated, some buyback when stock price is below NAV and some dividends when stock price is above NAV seems reasonable.

But I do definitely agree with the additional and more in-depth context you included, what ACAS management did requires extra diligence in making sure their choices past muster.

... to actually take point-by-point the rationale provided by the company for their actions .. examining each for accuracy, efficacy, check their data, their assumptions and conclusions .. and then come to your own presented in pointed contrast.

I must agree with your critics. Your article just doesn't cut it. In particular the facts surrounding the ACAS buyback are far different than the comparison examples.

The book value (which represents a mark to market of the value of all ACAS investments) is far above the current stock price. Leverage is manageable. The decision to buyback shares represents ACAS management's belief that making an investment in ACAS is a better opportunity than other investments they can find in the current market.

I agree with this assertion. Others may not which is fine too. You seem to focus on what appears to be irrelevant data (the stock issue is over and was needed to de-leverage which is no longer a concern).

Ultimately the market will coinfirm or reject whether the buyback is a good idea. I believe it will be strong confirmation.

To call buying back stock for less than book value a bad idea simply because stock was issued previously at a lower price make no sense. I hate to break it to you but very few companies completing buybacks right now are completing them at valuations lower than when the stock being bought back was issued. The real issue with buybacks is most companies buy back shares only to turn around and award stock based compensation – my view of buybacks are that typically they are a wealth transfer to the employees but that is not the point of this post.

Trying to judge the fairness of a stock issuance based upon book value is equally nonsensical. The stock was issued in April very close to the price at which it was trading on the open market. This is arguably the “truest measure” of the “fairness” of the offering price. This is, of course, without factoring in highly uncertain state of the economy which would argue in favor an even bigger discount to book and a significant discount to the market price.

In the quarter that closed immediately prior to the stock offering ACAS’ book value was approximately $9 and the stock was trading at 5$ or approximately 55% of book. Per the authors numbers, the book value at the time of the recent buybacks was 11.92 and the average purchase price $7.61, or approximately 63% of book. In short, the buybacks, in terms of percentage, were approximately as accretive to ACAS as the share issuance was dilutive. In terms of dollars, each share purchased back was purchased as at $4.31 discount to book while the shares sold in April of 2010 were sold at a $4.00 discount to book.

It is easy to look back and criticize management’s decision regarding the secondary in hindsight, but is simply not rational. Looking at the numbers, all in all, does not look like a bad deal to me.

Short term, I would love for ACAS to terminate the buyback and reinstitute a dividend. In this environment, everyone is search for yield and I expect the share prices to rapidly approach book if a dividend was instituted. However, long term the buyback makes sense.

By way of disclosure, I have been in and out of ACAS and am currently long.

Thank you for providing specific information (below) that should have accompanied Mr. Maxwell's introduction of the Poulson-sale/ stock-buyback comparison in the first place.

Though ..as both you and I have said as well .. it makes no sense to use that past sale as any justification or argument against the current stock buyback .. they are apples and oranges sitting on the same kitchen table years apart.

"In the quarter that closed immediately prior to the stock offering ACAS’ book value was approximately $9 and the stock was trading at 5$ or approximately 55% of book. Per the authors numbers, the book value at the time of the recent buybacks was 11.92 and the average purchase price $7.61, or approximately 63% of book. In short, the buybacks, in terms of percentage, were approximately as accretive to ACAS as the share issuance was dilutive. In terms of dollars, each share purchased back was purchased as at $4.31 discount to book while the shares sold in April of 2010 were sold at a $4.00 discount to book."

There was talk that Paulson might eventually sell or break up ACAS. The company's decision to buy back shares, which is suspect are primarily bought directly from Paulson, was motivated by nothing more than management's desire to continue to collect their very lucrative fees and protect their jobs. The whole thing is the worst sort of insider dealing.

About the only thing I would agree with in your article is that your bottom line is foolish.

You seem to want to use the ACAS buyback as the proof point for your thesis that buybacks are not in shareholders' interests. While that may sometimes be true, ACAS is not remotely close to a good example of that.

If one were to criticize management, it might be for being overly leveraged when the credit crisis unfolded. However, since then, management has significantly deleveraged the capital structure, including through the Paulson transaction, and is committed to a significantly lower debt ratio going foward.

So, now, using cash flow from operations and typical liquidity events for buying back shares at a 40% discount clearly creates shareholder value.

Perhaps you should retitle your column something like "Random Musings..." rather than "The Truth..."

His ownership percentage of Hartford is less than ACAS and he is virtually ordering them to break it up. Why should he breakup ACAS when management is willing to buy him out at a 40% premium to his purchase price?

Classic case of learning more by reading the comments than the article itself. Great dialogue (though some unnecessary personal attacks). I've been a happy and then sad and then happy again holder of ACAS for quite awhile. The financial crises rendered almost anything other than T-bills nearly impossible to value. The stated BV of ACAC was smashed as there essentially was no market for those assets and the best one could do is guess. When Paulson put his money in he took on a lot of risk - who knew then what those assets might really be worth? Give him his due. I certainly wasn't going to pony up any more at that time. I just hung in there hoping the markets would settle down before everthing was lost. Now, some semblance of sense has returned to the markets and I am much more comforatable with the accuracy of the stated BV. I think now paying $7.60 for assets worth $11.92 is a much safer deal than paying $5 for assets then estimated to be worth $9. So, in this case, I think share buybacks are a pretty smart move. Though I am looking forward to some cash some day. (For now I generate a little income selling covered calls).

The author appears to fall victim to the fallacy of the false alternative. In this case, the false alternative occurs by comparing the circumstances and opportunities at one point in time with the circumstances and opportunities at a different point in time. That is a false choice. In fact, given the change in circumstances, it is possible that $5.06 was a fair price at which to sell shares at the time and and today's price (despite being higher) is a bargain price at which to buy them.

As I see it, ACAS, and any other company for that matter, has four options on how to deploy capital. They are:

1) Do nothing with excess capital--this is the option preferred by Apple and other companies that merely sit on huge piles of cash, presumably waiting for an attractive use at some point in the future. You will never convince me that this is an attractive use of capital for any company. If there is no imminent use for the capital then it should be returned it to shareholders so they can use it.

2) Employ it in the business--in the case of ACAS, this means making mezzanine and equity investments in middle market companies. ACAS is actively seeking such investment opportunities, but has to weigh the returns on those potential investments against the potential return on its own stock which is selling at a 30% (approx.) discount to NAV. The market for mezzanine and equity deals is too competitive to have this much of a mispricing so ACAS has found few deals that meet the return profile of its own shares.

3) Pay a dividend--in the case of ACAS, this is not an attractive proposition for two reasons. First, ACAS has net operating losses for tax purposes that mean it does not receive a tax benefit for dividends as it did before it ceased its dividend a few years ago. Second, the alternative way to return excess capital to shareholders, the disparaged buy back, is accretive to EPS and is like buying dollars for 70 cents. If ACAS were to pay a dividend to me (I own shares) I would use the proceeds to buy more shares. Unfortunately, I would have to pay taxes on the dividend, creating substantial friction.

4) Buy back shares--to me, this is clearly the most attractive option for ACAS in comparison to the other options. There is always the risk that ACAS's stock price becomes cheaper, but that doesn't mean this is not an attractive price at which to buy the shares.

Unless the author compares the buy back option with ACAS's other uses for capital today, he has used a lot of words for nothing.

Gideon17, another option is to pay down the debt ACAS have remaining. But your point stands.

With Rich and John, I think their analysis veers more to whether they like ACAS the company/management/prospects versus having anything too constructive to say in regards to the buyback program. There's some value there, but as they frame their discussions around ACAS's buyback, it comes off as fairly inadequate (to put it nicely).

I agee with villainx, Rich and John do not like management, because they feel Malon Wilkus and company didn't forsee the banking crisis. It seem's odd that they could single out management at ACAS, when almost every company, every bank, political group, labor union, and certainly every home owner in the The U.S. didn't expect a recession of the magnitude that occurred. I don't agree that managment failed. I actually feel quite the opposite. I think they did a great job saving the company, and since, they have addressed their mistakes, and the leverage that caused the problems.

Villainx, Thanks for pointing out an additional use for ACAS's capital (i.e. repaying debt). Given the cost of the debt, I would argue, as ACAS has, that repaying debt is a less attractive option than buying back stock, but it is certainly one that should be considered.